Options Spread Trading Risks [Stay Protected]

Option spreads can be extremely risky, primarily if they are held through expiration. These positions can cause massive losses in a concise period of time on margin. To be aware of the risks involved in options spread trading, we need to understand the downside of every type of spread. This blog post will look at some of the dangers associated with option spreads and how you can avoid them.

Option Spread Explained

An option spread is a type of options trade that involves a simultaneous purchase and sale of two different options contracts with different strike prices and expiration dates. There are various options spreads, including the bull call spread, bull put spread, bear put spread, and bull put spread. They all involve the buying and selling of multiple options contracts, just different strike prices.

The main benefit of option spreads is that they can provide traders with a way to reduce the downside risk of their trades. By buying a lower-priced option and selling a higher-priced option, traders can create a trade that has limited potential losses and limited potential profits.

However, option spreads also come with some significant risks. One of the biggest dangers associated with option spreads is that they can be held through expiration. If the underlying security moves in the wrong direction, option spreads can quickly become very expensive and cause significant losses.

Understanding the potential dangers of option spreads is essential, and using caution when trading them to mitigate these risks.

The Dangers of Vertical Spread Option Spreads

As we have seen, option spreads come with several risks that traders need to be aware of. These risks are mainly created because of holding a short option contract. As a short option contract holder, you have no control over whether the option is assigned. If and when the option gets assigned, this will force the trader to come up with the capital for 100 shares of the underlying stock. While this seems scary and can be shocking seeing your account in a margin call, a very simple solution should fix this problem.

Option Assignment Explained

When you sell an option, you give the buyer of the option the right to purchase (in the case of a call option) or sell (in the case of a put option) 100 shares of the underlying security at the strike price. If and when this option is exercised, you are forced to buy or sell 100 shares of the underlying security at the strike price. This can create a problem if the option is assigned and you do not have the money to buy or sell the stock.

There are two solutions:

One solution to this problem is straightforward: own the underlying stock or have the capital to buy 100 shares of the underlying stock. By owning the underlying stock or having the capital, you are ensuring that you will be able to comply with any option assignments that may occur.

The second solution is to have a long call or put option; this will allow you to exercise the option. This is referred to as exercising the option; you can then sell or buy the underlying security at the strike price and get out of the margin. Later in this blog, we will talk about the max losses and risks associated which each type of spread.

Risks for Debit Spread

A debit spread is made up of selling a call at a lower strike price and buying a call at a higher strike price for the same underlying security. Debit spreads are meant for directional bets on the market that offer lower risk and lower costs. The example below is considered a bull call spread, a bullish strategy options strategy where the trader is looking for a rising stock price. You can see in the example below, the cost of the long call option is $1325, and an option with a short call strike price of -$1155 will result in a net cost of $170 for a bullish bet on a stock.

The picture below is a typical profit and loss chart based on the stock price at the time of expiration. You can see for a debit spread, the trade starts out negative because it costs money to get into and once the stock passes the breakeven point, that is why the trader will start making money. The maximum gain for this trade is $330 and the net debit is $170, which could result in a 200% profit potential.

Strike Price Assignment for Debit Spreads

The max loss for a debit spread position is the net premium paid for the spread or the initial cost. Luckily if the short leg ever gets assigned the trader will receive their max profit instantly once they exercise the long leg. So, in our example above, if the short contract leg gets assigned, you would gain $500 per contract. This max gain would occur when you exercise the long leg.

The process broken down is as follows:

1. Short leg gets assigned, which results in a stock sale and puts you in a margin call for -$112,000 per contract.
2. The long leg needs to be exercised, which would allow a stock purchase at $1,125 per share for a total of +$112,500 per contract.

This would make the net profit +$330 per contract. As you can see assignment for debit spreads is not as scary as it can allow for a max profit much quicker.

Risks for Credit Spread

A credit spread is made up of selling a call at a higher price and buying a call at a lower price for the same underlying asset. A bear call spread is a bearish strategy or neutral options strategy. Credit spreads are meant to collect premiums from time decay which allows traders to generate income. The vertical spread seller will look to make the full premium only if the stock trades sideways or reverses the direction of their calls or puts. You can see in the example below, the cost of the short call strike price is -$1325 and by buying an option lower for -$1155 we are able to possibly collect $170 for a bullish bet on a stock for the same expiration date. While a net premium of $170 may show up instantly in your account it will not be realized until the options expire worthless.

The picture below is a typical profit and loss chart based on the stock price at the time of expiration. You can see for a vertical spread, the trade starts out positive because the trader receives money to get into the trade and once the stock passes the breakeven point, that is why the trader will lose making money. The maximum profit for this trade is $170 which is also referred to as the net credit, while the maximum loss or maximum risk is theoretically -$330 for the call options.

Strike Price Assignment for Credit Spreads

The max loss for a credit spread is the difference between the strike prices minus the premium of the credit spread. So, in our example above, if the short contract leg gets assigned, you would lose $500 - $170 per contract. This max loss would occur when you exercise the long leg.

The process broken down is as follows:

1. Short leg gets assigned, which puts you in a margin call for -$115,500 per contract.
2. The long leg needs to be exercised, which would allow you to buy the stock at $1,120 or +$120,000 per contract.
3. You would keep the credit of the spread when exercising for +$170 per contract.

This would make the max loss -$330 per contract.

Missed Exercising Risk for Same Expiration Date

The biggest risk with spreads is holding until expiration. During expiration, short contracts can be assigned unknowingly, and if the trader fails to realize when this happens they will not be able to exercise the long leg of the contracts. Options will expire at 4:30 PM CST and not be able to be exercised at this time. That means that your only form of protection won't be able to protect you anymore. You're only chance of getting out of this margin call would be to buy or sell the shares of stock needed. The problem is that the stock may gap up or down the very next day which could result in massive unforeseen losses.

The process broken down is as follows:

1. Short leg gets assigned, which puts you in a margin call for -$112,500 per contract.
2. The long leg needs to be exercised but was not able to be because the trader may have missed the deadline.
3. The stock price falls down to $1,000 premarket the next day causing the brokerage to buy 100 shares of the stock at the market price to get out of the margin call.
4. This causes a -$12,500 loss on a trade that was supposed to have a capped loss at -$500.

The amount the stock gaps is the amount of money the trader will lose, which means the losses are typically infinite because you are at the mercy of the market makers. That is why it is always better to close out the short option contracts before expiration to avoid this significant risk. By doing this, traders can avoid having problems with assignments and exercising after hours.

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